Depreciation is Real - Don't get Caught Like I Did!

Took a call yesterday from a local investor. She is looking to "unload" some units. The problem - she wants above market prices...:)

And here's how this happens:

She owns a PIG. Translation - a building similar to the ones you CA guys buy turn-key in Ohio. You know - 70 years old functionally obsolescent crap with lipstick on it - you know the ones?!

BTW - looking at my T12, 3 out of the 4 houses I still own in my portfolio in Ohio lost money in 2014. Can you guess why - CapEx, otherwise known as replacement of depreciated components. Just sayin...

Well, she tells me that she'd just spent $35,000 remodeling the down-stairs unit (it's a duplex) and she wants that money back...

I spent 30 minutes on the phone (cause I am a nice guy) explaining to her that replacing electrical, plumbing, windows, fixtures, and all the rest of it was something that she HAD TO DO in order to make the place stay alive, but none of those things improve the rent or add to the value. At the end of the day, what she still has is a pig; just has some lipstick on it.

Depreciation is not just a tax break. Real physical items depreciate over time and eventually exhaust their useful life, at which point you MUST spend the money. But, you won't get it back.

Don't get caught by the real depreciation y'all. You can thank me later...or now :)

Your statement can be made of any town any city in America... it does not matter if you buy a 1920's built home here in Portlandia, the issues are the same... the difference is location and do you have an exit if you need to exit.. cap ex does not increase rent as you mentioned.. It is why values are where they are at by region... And why you have the great appreciation Vs cash flow debates.. And why its critical if one is buying cash flow properties to know what they are buying and the condition of the major components in the homes. Some of the most bullet proof homes I have ever financed were the little brick bungaloo s in Detroit.. those houses were built to last.. once you had new water sewer elec windows roof.. you have a home that could last for a few decades.. And now what I really like is what some of the guys in Chicago do with those same type of brick buildings that were built by craftsmen of yesteryear.. the guys I have been funding take them all the way down to the studs so its a awesome brick shell and everything is new inside everything. So its basically new construction.. But of course the values are far greater and the price of entry higher but for rental stock its pretty nice stuff...

35k to remodel or upgrade one unit of a duplex is pretty high unless it was a studs out remodel.. then she has another 30 years to recapture those out of pocket costs.

I think age definitely has a lot to do with that. Roofs, furnaces and water heaters are some things that can go. But things like electrical and plumbing are pretty age specific. If you buy a house that was built in the 70s/80's or above, you will likely not have to replace the electrical in a 20 or even 30 year window. But if you start getting into the 50's and 60's stuff, then maybe you will.

Same could be said for the plumbing too. Lesson I've learned is that if the water line coming into the house isn't copper, watch out. That galvanized stuff is going to go eventually and its not cheap to run new service. If your drains are pvc, you're probably good for the 20/30 years. If a combination of galvanized and/or clay, you might have to put in a whole new drain system or get dinged with a hefty repair at some point.

So I do think you can minimize some of the big expenditures based on the age of the home and the type of material they used for some of the elements like that.

Ultimately, though, if big stuff like that does go 10 or 20 years down the road, you should have built up more than enough cash flow and equity in the house that a 5k bill won't be that bad.

I still believe that the long term results with investing in real estate if you have the right product mix, you are going to do extremely well.

I would love to hear from any investors that have owned over 20 SFH's for over 20 years and see if any of them went under or if, as I would suspect, they're doing incredibly well.....

The small few that I've ever been able to talk to have all seemed to be doing incredibly well.

I can't say that I personally have owned anything for over 20 years, but several people I deal/work with have. The common phraseology is "Ounce of Prevention = Pound of Cure".

@Mike H. - Yes Galvanized stinks, which is why when we see it when first walking a property, we immediately plan to replace it and add that into our rehab costs. It is far more expensive to replace once it breaks and now you have water leaks, etc. Easier to do it when doing the initial renovation.

As to items like Hot Water Heaters, regular maintenance on them extends the life. Draining, flushing and even replacing the anode rod all are items you should do. Just like with a furnace, allowing a dirty filter to stay longer makes it work harder attempting to pull in enough clean ear to warm. It will also increase your utility bills.

For me, the largest expense is usually the roof. A bad roof leads to so much damage inside. Ensuring the flashing by dormers and the sealant in the valleys are good each fall before winter is critical.

Other than that, I have several properties built in the 1930s-1950s. Lots of Chicago "area" inventory was built post WW2 when all the troops returned and needed their own housing. So noting the age of a home is key to understanding what you should look for. Built before 1978, most likely had lead based paint, etc.

When I was on a tear and amassing 350 SFR's in areas were housing stock was POST WWW2 we did a few major items to each house.. if it was not obvious the roof had been replace in the last 5 to 7 years we replaced... If the waste line was still clay we replaced it prophylactically, the reason being we could get a sewer line replaced for 1 to 2k during rehab ... as opposed to having an emergency replacement with the tenant in the home and that costing 3k or more

Your statement can be made of any town any city in America... it does not matter if you buy a 1920's built home here in Portlandia, the issues are the same... the difference is location and do you have an exit if you need to exit.. cap ex does not increase rent as you mentioned.. It is why values are where they are at by region... And why you have the great appreciation Vs cash flow debates.. And why its critical if one is buying cash flow properties to know what they are buying and the condition of the major components in the homes. Some of the most bullet proof homes I have ever financed were the little brick bungaloo s in Detroit.. those houses were built to last.. once you had new water sewer elec windows roof.. you have a home that could last for a few decades.. And now what I really like is what some of the guys in Chicago do with those same type of brick buildings that were built by craftsmen of yesteryear.. the guys I have been funding take them all the way down to the studs so its a awesome brick shell and everything is new inside everything. So its basically new construction.. But of course the values are far greater and the price of entry higher but for rental stock its pretty nice stuff...

35k to remodel or upgrade one unit of a duplex is pretty high unless it was a studs out remodel.. then she has another 30 years to recapture those out of pocket costs.

That's the whole point - if the values are there to support doing it "the right way" then by all means. In that case this is not a pig. What I am talking about in Ohio is financial obsolescence because the market valuation is underneath the cost of doing things the right way, which leads to lipstick on a pig.

She did a total to the studs rehab apparently. Not by choice - the building needed it, and she has a conscience. Unfortunately, the market doesn't care...And, while I hope she lives another 30 years, considering her age I doubt that. She's caught...

It sounds like a nice little rental now @Ben Leybovich . The question I would have is what's going to happen going forward? Will there be a pay back over time or does it just keep getting destroyed? New place, good tenants or new place, bad manager, nightmare.

CapEx is an interesting thing to budget for. I had a friend who worked for a HUGE 100+ unit building, and they had a schedule for when everything would be replaced. The roof had been completely replaced, and was set to be replaced twenty years later. The electrical was rewired the next year, with scheduled replacement a few years after that. The plumbing, elevator, and all major systems were on similar schedules. In addition, every single unit in the building had all the flooring replaced, fixtures upgraded, etc. whenever they had a tenant move out of a non-upgraded unit. Simultaneously we upgraded the partial furnishings that came with the unit.

The transformation was tremendous--about 7 years after the building was acquired from a slum lord, after lots of small, carefully-planned steps, the building went from dingy to looking clean and rentable to quality tenants. And they did all this by being very thorough in their costing and planning, and carrying out the plan, one small step at a time, coming in every year under budget.

Of course, emergency flare-ups can still happen, but for the most part what I've seen is that approaching these older buildings with a very realistic and conscientious approach can allow you to properly value these buildings and slowly transform them. Within twenty years of purchasing a property, you should have budgeted to overhaul/upgrade all of the major systems, depending of course (as others on this thread have said) on the total age of the system. I also second @Dale Stevens ' point about regular maintenance.

CapEx is an interesting thing to budget for. I had a friend who worked for a HUGE 100+ unit building, and they had a schedule for when everything would be replaced. The roof had been completely replaced, and was set to be replaced twenty years later. The electrical was rewired the next year, with scheduled replacement a few years after that. The plumbing, elevator, and all major systems were on similar schedules. In addition, every single unit in the building had all the flooring replaced, fixtures upgraded, etc. whenever they had a tenant move out of a non-upgraded unit. Simultaneously we upgraded the partial furnishings that came with the unit.

The transformation was tremendous--about 7 years after the building was acquired from a slum lord, after lots of small, carefully-planned steps, the building went from dingy to looking clean and rentable to quality tenants. And they did all this by being very thorough in their costing and planning, and carrying out the plan, one small step at a time, coming in every year under budget.

Of course, emergency flare-ups can still happen, but for the most part what I've seen is that approaching these older buildings with a very realistic and conscientious approach can allow you to properly value these buildings and slowly transform them. Within twenty years of purchasing a property, you should have budgeted to overhaul/upgrade all of the major systems, depending of course (as others on this thread have said) on the total age of the system. I also second @Dale Stevens ' point about regular maintenance.

This is the professional approach to doing CapEx. This is why my syndicate can't pay as much as some others - we know this stuff is coming and need done, and we discount for it, while others do not. Inevitably this catches up to people - there is a reason why there are foreclosures in the aportment space :)

It sounds like a nice little rental now @Ben Leybovich. The question I would have is what's going to happen going forward? Will there be a pay back over time or does it just keep getting destroyed? New place, good tenants or new place, bad manager, nightmare.

There will be a rent increase, but not nearly of the magnitude that would result in capitalization of expenses that's close to reasonable. Besides, the owner is not 30, or even 60...This was a mistake...

@Juan Diaz that is called a reserve study. It calculates how much you need for reserves for upcoming capex events. My condo rental has 1.4 mil in reserves-35 year old complex.

Nothing good started happening for me until I started thinking long-term. I enjoy improving places slowly over time with cash flow. Having awesome appreciation makes it a whole lot more satisfying though.

Sure @Ben Leybovich sell me all your stuff on contract for 0 down, no late penalties for late payments, no recourse of course, and a little negative amortization to boot. Go ahead and retire because you've been working too hard-some nice beach-leave the driving to me. Know any good long distance property managers? I am on a 4 hour work week and can't be bothered with the day to day details of your old properties. Hope it all works out. Oh yeah, they will all be in their own LLC's held in a holding company in another state.

Sure @Ben Leybovich sell me all your stuff on contract for 0 down, no late penalties for late payments, no recourse of course, and a little negative amortization to boot. Go ahead and retire because you've been working too hard-some nice beach-leave the driving to me. Know any good long distance property managers? I am on a 4 hour work week and can't be bothered with the day to day details of your old properties. Hope it all works out. Oh yeah, they will all be in their own LLC's held in a holding company in another state.

Great post, and couldn't agree more with what you're saying. I think this is the biggest thing that catches newbies off guard down the line - and I'm saying that from personal experience BTW.

We only have one apartment building right now, and it was only after a few years of owning it that the light bulb went off in my head about these little $30K to $40K houses that we can pick up around our apartment building. At first glance, they look like great cash flowing investments, but if you're only generating $100 to $200 per month in cash flow, you might get a good ROI on paper, but what happens when the AC goes out? Where we're investing, that's a $2500 to $3000 replacement cost. Pfffft, there goes all your cash flow for a year or more. A roof can be $5000 - now you're talking potentially several years of cash flow. You haven't bought an investment, you've bought a money pit.

I'm not automatically against buying the cheaper houses as investments, but we better be able to get it at a price where it cash flows and we can rehab it 100% new so the maintenance costs stay low for many years into the future. Otherwise, it's a painful lesson waiting to happen - ask me how I know :).

@Ben Leybovich Thanks for the topic. I like figuring out these costs on the purchase, but posts like these have helped improve my long term planning. One item I find interesting on these old homes (one of my markets has the oldest housing stock in the nation) is the number of owners over a relatively short period of time. I think the realities catch up with them fairly quickly. For these old homes I like to the studs rental remodels built into the purchase price. I get nearly all the capex out of the way and I have modernized the units rather than slapping new items in with antiquated items.

@Jeff S. - I am going to vote for that post about the 4 hour work week stuff. That is classic. Anyone that buys that BS just wasted their money. Love when I get an auto-respond e-mail saying the person only reads their e-mail two times a day (something taught in that book 4 hour work week). WHO CARES if you can't manage your time. Oh wait, now I do. If you can't manage your time to where you have to put an autoresponder on, I am not doing deals with you.

With that being said. Cheap homes can work, if you don't treat them like cheap homes. Their items break down the same as other homes do. So it is incumbent upon you, as the owner/investor, to put together a site maintenance plan and reserve study. You must realize that each yea you have to put aside some funds to replace things eventually. Example say a furnace lasts you 15 years. You just put a new one in, so you need to plan to replace it in 15 years. Start setting aside funds for it now. Let's say $3,600k is what will be needed (just a guess here for easy math) Divide 3,600k by 180 months. $20 a month is what is needed. Simple things like that can really add up, but that is what we must plan for as property owners. EVERY SINGLE PROPERTY faces this same issue. Doesn't matter if they are $1M or 10k.

Doing routine maintenance and lowering your initial cashflow will result in less stress, and longer returns for THE LONG TERM!!!

I had an investor client that sold me a couple of his highly maintenance deferred properties. He was a genius at not spending money @Dale Stevens . When the carpet would wear out he lay a new hunk of carpet over the old and nail it with a 16 penny nail gun. He also stacked roofs like crazy. Did all his own work and it showed...the plumbing he did was laughable. And he didn't paint much either. He just sucked money out of these places for many years. That was "old school".

Being willing and able to improve properties is a function of the economy and a philosophy about being a landlord. Right now times are good and people can afford to improve their places but when times get tough and we are dealing with vacancies and bad tenants it becomes another matter.

Apparently you are able to put money away for repairs in your area and still make money. That is good. And apparently, @Ben Leybovich is in an area where that is not feasible.

The cheapies are interesting to us who salivate at these numbers but when push comes to shove I think you have to run a very tight ship to make it work. That means being around there when renting and when work is done IMO.

I had the worse house on the block. I transformed it to one of the best houses on the block. Slumlords are scumbags. I learned from my parents to do things the right way. Yes I was over budget by 10k.

When you start taking off the siding and see the dumpy windows and know they are garbage just replace them. When you have 1970's honey oak cabinets you just blow them out and get nice white solidly build from Lowes. You don't put in the old nasty sink you replace that also.

This property sat empty for 4 yrs. Plumbing blowouts everywhere. I replaced all the valves in the house. Do it now, why wait till you have a tenant. The plumber is already there so just do it.

My house could sell right now and I would make 10k. I rented it in 4 days @800 for a 2bd. These people love this house.

to use your reserve study and math... then pretty much any rental that makes maybe 200 a month positive cash flow is really break even... because over the 30 years you will need to replace almost every major component and not to mention tenant abuse.

and of course everything will cost double in 15 years to what we pay for it today...

YOu make some good points... and I think that's why when there are post where others want to know how its going for those that have owned rentals for 10 years or longer its hard to get people to respond or there are not many as cash flow VS reality set in at about 5 years and I think many choose to sell before the big ticket items come up...

For me long-term (poor sucker) my costs for maintenance, repair, and capex is over $200 mo. With this I can buy something and get it up and running and keep it for the long haul. Living conditions are good and tenants happy and stay. Curious @Dale Stevens what your monthly reserve is for these expenses/capex.

Have not tried to make this a sole source of income so not worried. In my area you need to be well heeled to buy the bigger better stuff so it has been slow for me.

My hat is off to you guys that actually live off your RE @Ben Leybovich . I would love to do what @Dawn Anastasi does but the opportunity hasn't been there and traveling up to this date has been out of the question.

The wealthy investors I grew up around bought and held for many years and became millionaires quite a few times over. Two of them kept buying right up to the end (their 80's).

That is the beauty of RE there is no age discrimination and the successful many times don't ever stop.

My hat is off to you guys that actually live off your RE @Ben Leybovich . I would love to do what @Dawn Anastasi does but the opportunity hasn't been there and traveling up to this date has been out of the question.

The wealthy investors I grew up around bought and held for many years and became millionaires quite a few times over. Two of them kept buying right up to the end (their 80's).

That is the beauty of RE there is no age discrimination and the successful many times don't ever stop.

I put away 15% approximately for maintenance/CapEx. There's not a threshold of when to "stop" putting money away per se. You can't just have $1,000 in your maintenance fund and decide enough is enough. You could have a major issue come up and the money has to be there. Some people say that a percentage isn't the way to go, you should really figure out the remaining life of everything and work out the math. Whatever way you do it, just be sure to have enough money!

I know Ben doesn't like "cheap properties", but my "cheap properties" are well maintained, tenants want to live in them, and have afforded me the ability to live off real estate investing. So there's something to be said about them.

How many years have you been doing this @Dawn Anastasi ? You are also very handy which is very cool. I would imagine contractors work for less there so that must help. I had a new roof on a duplex done (granted there were 3 layers and dryrot-1910 bldg) and it cost around 12k. That was the lowest of 3 bids. And then we have lead based paint people and huge fines for touching your exterior. Paint jobs not long ago 2k now 4-5k with lead certified contractors. Ever have any chimneys rebuilt? Think that was around 4k. Should have been $500 IMO.

How many years have you been doing this @Dawn Anastasi? You are also very handy which is very cool. I would imagine contractors work for less there so that must help. I had a new roof on a duplex done (granted there were 3 layers and dryrot-1910 bldg) and it cost around 12k. That was the lowest of 3 bids. And then we have lead based paint people and huge fines for touching your exterior. Paint jobs not long ago 2k now 4-5k with lead certified contractors. Ever have any chimneys rebuilt? Think that was around 4k. Should have been $500 IMO.

I've had a couple chimneys tuckpointed but not completely rebuilt brick by brick. The tuckpointing jobs were around $400 each. I had to have asbestos siding removed on a duplex and that was expensive for the asbestos removal.

I've only been investing in Milwaukee for about 4 years. I used to do a lot more "contractor-type" work myself but have since gotten away from that and just hire jobs out. I don't even do my own housecleaning or grass cutting or snow removal any more. I guess I've gotten pretty lazy! :)